Inverse Index Mutual Funds to Hedge Against Market Declines

Both short selling and inverse index funds can benefit when markets fall. But they work differently.

Inverse Index Mutual Funds as a Alternative to Short Selling

If you have spoken to a financial professional, you have probably heard that they believe a stock market correction is overdue. It is not surprising since the stock market has been more than bullish for over a decade. No retiree or pre-retiree wants to live through a stock market “correction.” Negative stock market returns can wipe out your retirement plan, especially when they happen early in retirement.  In retirement, preservation of capital is as important as seeking additional growth. Can inverse indexed mutual funds help?

Principal Protection Programs protect portfolios from losses, but how can you make money on the declining stock market? Families working with us know that our portfolio managers aim for positive returns even during stock market declines. How do they do it? Do they “sell shorts?” No, they don’t! Long pants with belts and suspenders are more our conservative investment style. 😉 Our goal is to reduce portfolio risk, not to increase it. That’s why sometimes we make short-term investments in inverse index mutual funds to protect client’s portfolios.

What Does It Mean to “Short” a Stock?

Short selling (or shorting) reverses the normal order of investing. Normally, an investor buys first and sells later. With short selling, the investor borrows shares for a certain period of time, sells them, and hopes to buy them back later at a lower price to return them to the lender. Basically, you sell shares you don’t own yet at the current market price. When you buy these shares back later at a lower price and return them to the lender, you get to keep the profit.

But what happens if you are wrong? If the stock rises in value instead, replacing those shares will cost more. The higher the stock price, the bigger your loss.

This is what makes shorting especially risky. A stock purchased for $100 can only fall to zero, but there is theoretically no limit to how high a stock can rise. A single stock price could double overnight! Therefore, the potential loss from a short sale is theoretically unlimited.

Borrowing costs and potential margin calls only make shorting riskier. You might also be responsible for the dividends paid by the company while you are holding a short position.

Shorting can be very profitable, but it is also extremely risky. That’s why we don’t sell shorts, even if we think the stock market is likely to decline!

Instead, of the high risks of shorting, we sometimes make short-term invests in inverse index mutual funds.

What Is an Inverse Index Mutual Fund?

They are designed to move in the opposite direction of an index. But unlike with shorting a stock, a single stock having a huge up day will not make a significant difference in a broad stock market index. The diversity of the index holding makes an inverse indexed mutual fund less volatile than an individual stock short.

For example, an inverse S&P 500 fund may seek approximately the opposite of the S&P 500’s daily return, before fees and expenses. If the S&P 500 falls approximately 3% on a particular day, the fund may seek to gain approximately 3%. If the S&P 500 rises 3%, the fund may lose approximately 3%.

The fund generally uses financial contracts such as swaps, put options, and futures to create this opposite exposure. The investor does not establish short positions in any single investment. Therefore, the risks associated with single stock shorting are not present. There is no borrowing of the shares, no margin calls, and no need to cover the shorts.

Investing in an index fund also provides some diversification and removes company-specific risk. With the broad diversity of hundreds of stocks, a sudden price change of a single stock has a small effect on an index, which reduces investment volatility. This is why inverse index funds can be purchased in most retirement accounts.

How to Use Inverse Funds to Your Advantage

An important characteristic of inverse funds is that many of them are designed to produce the opposite return of an index on a daily basis. That word, daily, is important. Inverse funds are not necessarily designed to provide the exact opposite return of an index over six months, one year, or several years because the funds may reset their exposure every trading day. Inverse index funds should be a short-term investment strategy. By short-term, we mean no longer than a few days. They should not be held long term.

Markets repeatedly move up and down. The goal is to invest in an inverse index fund for a short period of the decline and get out of this fund quickly once the downtrend reverses. Investors need to understand exactly how a particular inverse fund is structured and what its trading limitations are.

Since we believe the typical holding period for inverse index mutual funds should be very short, we also believe these funds are best used with automated (computer algorithm) trading systems calling the buys and sells only sparingly and in certain circumstances. Thus, we suggest you view the alternative investment section of our website.

The Bottom Line and Take Away

Short selling and inverse index strategies can both potentially benefit when markets decline, but they should not be viewed as two similar things. When selling short, the investor accepts the risk of unlimited losses that could happen overnight.

An inverse index fund allows the investor to purchase a fund that gives inverse exposure to a broad index without maintaining a traditional short position which could be riskier.

Frequently Asked Questions

What is short selling?

Short selling is a strategy where an investor borrows shares, sells them at the current price, and hopes to buy them back later at a lower price. The investor keeps the difference if the price falls, but owes the difference and the original purchase price if the price rises.

What is an inverse index fund?

An inverse index fund is a fund designed to move in the opposite direction of an index. A inverse S&P 500 fund generally seeks approximately the opposite of the index’s daily return, before fees and expenses, usually by using derivatives such as swaps, put options, and futures inside the fund.

Do inverse funds have borrowing costs?

The shareholder does not receive a separate stock-borrowing bill. The fund, however, has operating expenses, and the derivatives used inside the strategy carry their own trading and financing costs that are reflected in fund expenses and performance.

Why does an inverse fund not match the index exactly over a year?

Most inverse funds reset daily. Because returns compound each day, a choppy market can leave the fund with a result that differs substantially from simply reversing the index’s longer-term return. This is why inverse funds are best suited for only short-term investing. We interpret short-term as only few days or weeks.

Are these strategies appropriate for retirees?

That depends entirely on the individual, the purpose of the money, and the time horizon. Bearish strategies involve real risk of loss and should be reviewed with a Certified Financial Planner before being used inside a retirement plan. We believe that since inverse index mutual funds should only be used on a short-term basis, they are not appropriate for buy-and-hold strategies. We believe inverse index mutual funds are most appropriate for automated trading systems who uses them only sparingly in certain circumstances.

Contact us at Serenity Wealth Management if you would like to learn more about:

• Inverse index mutual funds
• Principal protection
• Multiple directional investing
• Hedging accounts from market declines
• Alternative investments
• Computer algorithm account trading

References

1. U.S. Securities and Exchange Commission, Office of Investor Education and Advocacy. Investor Bulletin: An Introduction to Short Sales.

2. FINRA. Non-Traditional ETFs FAQ and guidance regarding inverse and leveraged investment products.

3. ProFunds. ProFund VP Bear Summary Prospectus. Example of a -1x daily inverse S&P 500 mutual fund and its use of swaps, futures, daily rebalancing, and fund expenses.

4. Chovancová, Božena, Michaela Dorocáková, and Dagmar Linnertová. Two Investment Options for Bearish ETF Investors: Inverse ETF and Shorting ETF. International Journal of Financial Studies, 2019.

5. Drechsler, Itamar, and Qingyi Freda Drechsler. The Shorting Premium and Asset Pricing Anomalies. NBER Working Paper No. 20282, 2014.

This article is intended for educational purposes only and should not be interpreted as a recommendation to purchase, sell, or short any particular security or investment product. Investment strategies involving inverse exposure, derivatives, short sales, or market timing involve risk and may not be appropriate for every investor.